Tax departments should be prepared for audits of tax-exempt bonds.

• Author: Hani, George A.

When asked why he robbed banks, Willie Sutton responded, "Because that's where the money is." A similar spirit has informed the early efforts of the Internal Revenue Service's Tax Exempt Bond (TEB) Group in its choice of which bonds to audit. There appears to be a strong preference for auditing bonds whose proceeds have been lent by the issuer to large corporations ("conduit borrowers"). Tax departments in companies with tax-exempt financing need to be alert to the potential for audits of their bonds and need to take steps to ensure that their companies are prepared to defend those audits. Document retention and fact development is key, and corporations should be mindful that their normal Large and Mid-Size Business Division audit cycles and statutes of limitation do not apply.

Audits of tax-exempt bonds can create substantial financial exposure to companies. For example, if the IRS determines that a $50,000,000 series of bonds with a 5-percent coupon does not qualify as tax-exempt, its opening offer to settle the case without taxing the bondholders would be for the conduit borrower to pay more than $2 million plus interest and redeem the bonds (thereby causing the loss of lower-rate financing). Any amount less than the opening offer would have to be justified by factual hazards of litigation.

Given this potential exposure, taxpayers must be prepared to prove the exempt status of their bonds. For example, in the case of bonds issued to provide industrial sewage facilities, the taxpayer must be able to prove that the subject wastewater meets the biochemical oxygen demand limits set forth in the Treasury Regulations. For taxpayers who have obtained financing through qualified small issue bonds, the taxpayer must be able to prove compliance with the capital expenditure limitations that extend three years after issuance of the bonds. For any exempt facility bond, the taxpayer must be able to prove that there has been no change in the use of the facility to a non-exempt use.

A Brief History of Tax-Exempt Bond Audits

Before the early 1990s, the tax-exempt finance industry was largely self-regulated. The IRS had no organized audit program. Compared with other self-regulated industries, the tax-exempt finance industry performed fairly well. The industry was dominated by a handful of nationally-recognized, leading bond law firms whose tax partners consulted with one another regularly (by conference call) on whether given financing approaches satisfied the Internal Revenue Code requirements (sections 103 and 141-150) for tax exemption. Most issues of tax-exempt bonds were the product of a consensus of these firms, and the IRS did not question their bond opinions.

If a given firm wanted to be more aggressive, or developed a proprietary strategy, it sought a ruling from the IRS Chief Counsel's office rather than consult with the other law firms. If it obtained the ruling, it had at least a 90-day marketing head start to contact potential bond issuers before the redacted ruling was published and other firms began to reverse engineer and market the transaction themselves. In the event a law firm outside this close-knit community issued an opinion on a more aggressive financing without either the support of the other firms or a ruling, an article might appear on the front page of The Bond Buyer (the industry publication), which could lead to either IRS inquiry, a Treasury press release that the bonds might be taxable or, in extreme cases, an actual audit. These problem bonds were very rare.

In the early 1990s, the IRS began examining tax-exempt bonds in connection with exempt organization (EO) audits of hospitals and universities. While the IRS developed some audit expertise in the area of these so-called section 501(c)(3) bonds, that expertise was not applied to the wider world of government obligations and private activity bonds. A 1993 General Accounting Office report criticized the reliance on self-regulation in the tax-exempt finance industry and recommended that the IRS institute a more active audit program.

A significant impediment to any audit program was the fact that the taxpayer subject to audit was the bond-holder, whereas the facts relating to whether tax-exempt bonds...